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A friend of mine had a hedge fund interview a couple years ago and he showed an interview question that I cant find to answer to:
The headline is RISK-Neutralization
Real-world asset dynamics is mean-reverting:
dS =- lambda(S-s0) dt + vol * dW
•If volatility is 25 and MR is 50% (quite extreme), then the 1y distribution has standard deviation ~20
(basic Vasicekmaths)
•Question: what is the fair price of a 1y call? Is it BS(25) or BS(20)?
I assume that the BS() is the standard call price in black Scholes with vol = 25 or 20.
I assume that it it doesnt matter which if the option is ATM, Out/in -the-money
hmm, how do I get around. The answer that neither is correct but one is better than the other one. Pleace comment
The headline is RISK-Neutralization
Real-world asset dynamics is mean-reverting:
dS =- lambda(S-s0) dt + vol * dW
•If volatility is 25 and MR is 50% (quite extreme), then the 1y distribution has standard deviation ~20
(basic Vasicekmaths)
•Question: what is the fair price of a 1y call? Is it BS(25) or BS(20)?
I assume that the BS() is the standard call price in black Scholes with vol = 25 or 20.
I assume that it it doesnt matter which if the option is ATM, Out/in -the-money
hmm, how do I get around. The answer that neither is correct but one is better than the other one. Pleace comment
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